This article explains what Relative Strength is:
Why it is important, & Why the PRS concept works
- Relative strength numbers tell us how a stocks three, six, or twelve month returns measures up against all other stocks on a scale of 1 to 99 with 1 the worst and 99 the best.
- If a stock has a Relative Strength of 99 it has outperformed 99% of all other stocks while 1 indicates all other stocks have outperformed that stock over the given time period.
So how much has a stock with a 3-month PRS of 99 gone up? The answer is, it depends. At the end of a bull run the percentage return will be high and at the end of a bear market and or correction the percentage return will be low.
While a return may be high or low, it is all relative. If the best stocks have low returns then the worst stocks will be down a lot. People want to own the best stocks, the ones with high Relative Strength Numbers.
The stock below, TIE, displayed remarkable Relative strength. All three metrics, 3, 6, and 12-Month PRS metrics remained virtually pegged at 99, (They can't go any higher than 99) for well over a year. During this time, TIE was virtually the best performing stock in the market.
Why it works
Stocks with High Relative Strength Numbers tend to be dynamic companies with new products and services. They tend to have strong earnings grow and especially strong expectations going forward. The key is they are typically in the news. They have a buzz and people are talking about them. They are going up and everyone loves the winners. This attracts even greater interest and it is why the best stocks tend to keep going higher.
It is the same reason pretty girls are popular in High schools. Boys naturally tend to see them as the best and they tend to have a buzz about them. And lots of boys want a date with the popular and pretty girls. Well, in the stock market this facet of human nature is no different. Everyone wants in on the hot action and it becomes self perpetuating. It is this aspect of natural human desire the PRS Report capitalizes upon.
First things first, What exactly is Relative Strength?
Relative Strength as I use it refers to how one stock is doing relative to all other stocks. The stock that has gone up the most in a 12-month period is the Best stock. The best stock will have a 12-month Patterson Relative Strength (PRS_12) of 99 meaning it is in the 99th percentile. The 99 means the stock has gone up more than 99% of all other stocks in the past 12 months. Owning a stock for a long time, meaning 8 to 16 months, and seeing its PRS_12 reach 99 is a wonderful thing. It's great because the stock will have gone up tremendously, and it means you own one of very best stocks in the market. Everyone wants to own the best and that's what PRS Report is focused on.
On the flip side, a stock with a PRS_12 of say 10 means the stock is in the 10th percentile. This means over the past 12 months the stock has done better than only 10% of the stock in the market. In other words, 90% of the 6500 stocks I track went up more over the past 12 months than a stock with a PRS_12 of 10. By the nature of the system, the PRS Report avoids under performing stocks.
Performance is all Relative. I am often asked the question, how much has a stock with a PRS_12 of 90 advanced? The answer depends what the market did over the last 12 months. At the top of a bull market the 90th percentile will have advanced 200% or more over the past 12 months. At the bottom of a bear market, the 90th percentile might be up only 25%. So when you see that a stock is up or down a lot over a given time period, when trying to determine how well it has done you must first understand what the rest of the market did during the same period. Once you understand what the market did you can understand a stock's performance relative to the market.
Here is an example of how just looking at a stocks percent move can be misleading. Let's say a stock has advanced 30% over a 12-month period. A 30% return is a very good return over a 12-month period right? Well, what if the stock managed to reached that return while the 90th percentile was up 150%. 30% is still good, but it pales in comparison to the 150. In this case we have two stocks that have advanced, the difference being one performed much better on a relative basis. I don't know about you, but I know which one I would rather own.
Relative Performance is not a complicated concept; however, for many investors it is a new way of thinking. At Tame Trading our goal is to achieve strong returns over time. The main thing is we understand the word strong does not equate to a given percentage. Strong is used in a relative context. When the market goes down, strong means better than the market even though the actual number may not be very big. When the market goes up, Strong means big numbers that are better than the market. By focusing on stocks that continue to perform better than the overall market, meaning their PRS numbers are high, we are well positioned to benefit as the returns from the best performing stocks over time will be better than the market.
Why is Relative Strength Important and Why it works
A stocks Relative Strength is important because it tells us how much attention a stock is getting. Stocks with relative strength of 50 are running in the middle of the pack. Maybe it is improving, maybe it isn't, but is anyone really interested in the middle of the pack. Really strong stocks with high PRS numbers are dynamic companies that are in the news. Everyone wants to own the best stocks. The reason why the PRS system works is the same reason high-school boys chase the prettiest girls around year after year. It is human nature to want to be associated with the Best, and the PRS Report keeps you focused on the best stocks that investors want to be in.
The fact investors and money managers want to be in the best stocks means there is likely to be steady demand for these issues. That is actually what keeps driving them higher, steady demand, meaning people continually want to buy the best stocks, which drives them even higher.
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